How to Diversify Your Portfolio to Handle a Market Correction

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Your portfolio might be large-growth heavy if you haven’t rebalanced in a while. Growth has delivered an impressive run and boosted many funds this year, yet it’s only been a couple of years since a selloff walloped the category. Well, how can you diversify your portfolio as the year wraps up to reduce the risk from a correction? I talked with Russ Kinnel about some ways to do that. He’s the director of ratings for Morningstar Research Services and editor of Morningstar’s FundInvestor newsletter. Thanks for being here, Russ.

Russel Kinnel: Great to be here.

Hampton: Well, you’ve recently celebrated a milestone here at Morningstar, 30 years in one place. How do you feel?

Kinnel: Good. Good. It is kind of amazing to look back at how things have changed, but yeah, I feel good. I feel like it’s been fun to be part of the fund industry’s growth and Morningstar’s growth, and I think of how much the industry’s changed. Yet at the same time, we’ve got great innovations that are making investing easier, and we’ve got awful innovations that are making it easier for you to lose your money. So that’s never changed. It feels like there’s still a lot of need for the work we do here at Morningstar, researching investments.

Hampton: And you’ve been a big part of that, and congratulations.

Kinnel: Thank you.

What Is Driving Growth’s Impressive Run?

Hampton: We are going to tap into your wealth of knowledge today. Growth has had an impressive run this year. What’s driving it?

Kinnel: Yeah, artificial intelligence is a big part. Weight-loss drugs are a big part, and more recently we started to see interest-rate cuts. And growth companies love that because a growth investor is discounting out those future earnings further into a future than a value investor is so that when interest rates are lower, that means those future earnings look even better.

Why Is It Important to Rebalance Now?

Hampton: Now, growth has been good to some investors. Why do you think it’s important to rebalance now?

Kinnel: Right, so I’m not saying sell all of your growth because it’s a vital area. I still have a lot of money invested in growth, but if you’re now really overweight growth, it’s not a bad time to invest outside of that because after these big runs, sometimes you’ll get a correction. No guarantees we might get another big year. It’s just hard to predict. But I do think it’s a good time. Your portfolio may be more out of balance after a big runup like this.

What Triggered Growth’s Largest Selloffs Since 2000?

Hampton: And I’m going to ask you to give the audience a mini history lesson just in case they still need some convincing. Growth crashed five times, going back to 2000. So we got 2000, 2001, 2002, 2008, and 2022. What triggered these selloffs?

Kinnel: Right, and each one was a very different case. So, the 2000 to ‘02 bear market started off with speculation being crazy. We had dot-com’s first overenthusiastic rally with some crazy valuations, but we also had the Y2K effect, which was everyone needed to update their software and hardware for code, too, because a lot of code had been written with just two digits. You needed four digits. And what happened was a lot of businesses said, well, the easy way to do that is we’ll pull forward our spending on servers, hardware, and software. But a lot of people thought that that was just the beginning of a new era, and we were going to do that every year, but in fact, it was partly just a ‘99-only phenomenon. So a lot of that spending declined. And also we just had crazy speculative excess. So growth was really due for a correction after a huge runup in the ’90s.

But then we also had a recession partly related to 9/11 in ‘01. And of course when you have a bear market, generally you overdo it just as you overdo the bull markets. And so ‘02, everything really fell apart, and it was a really harsh, grinding market. So you had kind of too much speculation, a bear market, and just a really harsh dose of reality for investors. Then ‘08, very different financial crisis. Lehman Brothers, banks all in trouble. So the crisis wasn’t centered in growth stocks, but growth took a big hit nonetheless. Then ‘22 was a little different. It wasn’t even a recession. It was inflation leading to a spike in interest rates, which then led to that growth correction. So three very different environments.

What Was Unusual About the Growth Correction in 2022?

Hampton: And that correction in 2022 followed the rally that happened two years earlier, and you just mentioned high inflation. We also had rising interest rates. Were those circumstances unusual during a growth correction?

Kinnel: Yeah, I think more often you have a growth correction because of speculative excesses, or it could be a recession. So I think somewhat unusual, but of course it had been a long time since we really had had inflation and a big interest-rate spike. But if you look over the history of time, it’s not so uncommon. So maybe it won’t be another 25 years till the next time that happens.

Top-Rated Bond Funds That Could Help With Saving for an Emergency Fund

Hampton: I’m going to bring this up. You’ve written in the Morningstar FundInvestor newsletter how to diversify away from large-growth risk. Let’s start with top-rated bond funds that could work for retirees or folks like me saving up an emergency fund. What do you got for us, Russ?

Kinnel: That’s right. So the exercise was, let’s look for lower R-squareds and Medalist funds. And I started with core bonds, which are naturally a good way to diversify from equity in general, but in particular large growth. So, among the core bond funds with lower R-squareds that we really like are JPMorgan Core Bond and JPMorgan US mortgage. And the reason is both funds have a lot of asset-backed securities, and those securities tend to do a little better or lose a little less when interest rates rise. So that’s one reason, but also they’re just well-run somewhat defensive funds. So those are among the better options, but really any high-quality bond fund is going to be a pretty good diversifier from large growth.

Bond Funds That Are Defensive If Growth Gets Crushed

Hampton: And what other types of bond funds would work or play defense if growth gets crushed?

Kinnel: Yeah, I think of two other areas. Muni bonds are great. Munis tend not to be that tied to the economic cycle. They can tax their way out of most problems, but also defaults are pretty rare even in a recession for munis. So I like Fidelity Intermediate and Vanguard’s Intermediate fund. Both are good core holdings for a taxable account. And then of course, short-term bond funds are great for protection from just about any selloff. They did lose a little in ‘22 when interest rates spiked, but generally they’re very good defensive plays. I think Vanguard and Fidelity, again, have very good short-term bond funds. The catch with those is obviously returns are limited, but they’re a very nice defensive play. They’re a good thing to hold for short-term needs, obviously as well. If you’re going to buy a car, or your kid’s going to college in a couple of years, that’s a good place to stow some money.

Hampton: Things to note for later, Russ?

Kinnel: Yes.

Small-Value Funds Out of Sync With Large Growth

Hampton: Now gross outperformance can overshadow small value, but investors can find some deals. Which small-value funds have not been in sync with large growth?

Kinnel: So, I think of a couple. One is Royce Small-Cap Special run by Charlie Dreifus, who’s really kind of an accounting-focused manager and tends to really dig into balance sheets. He really looks to avoid accounting gimmicks, and it’s a very good defensive fund. So, that’s a fund that really tends to do pretty well when growth is not doing so well. LSV Small Value is another one that’s kind of different, though. It’s more of a deep-value quant-run fund, but again, miles away from large growth.

Hampton: And I think you were telling me earlier that you own one of those funds.

Kinnel: That’s right. I own Royce Special. I’ve owned it for a long time. It’s in our 401(k), so I’m a big fan.

Mid-Growth Funds That Are Good Diversifiers

Hampton: All right. And finally, which diversifiers do you like in the mid-value category, Russ?

Kinnel: Yeah, American Century Mid Cap Value is a nice one. It has, again, got a fairly low R-squared versus the large-growth area because they’re very much value-focused, looking for good companies that are fairly cheap, and they tend to be pretty different from large growth. So recently the fund has been kind of a boring performer because, again, it really doesn’t have any of that growth exposure but pretty reliable. Harbor Mid Cap Value is another good one that’s actually subadvised by LSV, who I mentioned earlier. Again, a kind of quantitative deep-value strategy.

Hampton: Well, Russ, thank you for coming to the table and congratulations on 30 years at Morningstar.

Kinnel: Thanks, I’m very old.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.